Why Switzerland suspended most favored nation status accorded to India

Switzerland last week announced its decision to unilaterally suspend the most favored nation (MFN) status it had accorded to India in 1994 under the double taxation avoidance agreement (DTAA), citing a 2023 October Supreme Court judgment.

The decision comes as a big blow to Indian businesses operating in Switzerland as they will now have to pay a 10% tax on dividends and other incomes with effect from 1 January, up from the earlier 5%.

What is the contentious MFN clause in India-Switzerland DTAA?

The India-Switzerland DTAA (DTA IN-CH) was signed on 2 November 1994, and subsequently amended in 2000 and 2010.

The agreement sought to smoothen cross-border trade and investment by mitigating risks of double taxation.

The most favored nation clause in the taxation agreement mandates that countries offer no less favorable treatment to investors from partner nations than they do to investors from any other country.

This means, for example, that any tax reductions or extra benefits that Switzerland grants another nation should apply to Indian firms.

What did the Supreme Court rule?

On 19 October 2023, the Supreme Court ruled in a case involving Swiss multinational firm Nestle that most favored nation benefits could not be automatically applied to the India-Switzerland treaty unless explicitly notified under Section 90 of the Indian Income Tax Act.

The apex court also interpreted that the MFN clause applied only to countries in the Organization for Economic and Cooperative Development (OECD) as of 1994, the year the treaty was signed.

This excluded subsequently added OECD members, such as Colombia and Lithuania, from the scope of the MFN clause.

The Supreme Court order made Nestle liable to pay a higher tax in India. Nestle had pleaded that it should be taxed at a lower rate because of certain DTAA provisions that were added when it was amended in 2010.

Switzerland, however, disagreed with the Supreme Court’s interpretation on two grounds.

First, it viewed the MFN clause as automatically applicable, which allowed it to extend reduced tax rates to India based on benefits granted to newer OECD members such as Colombia, which joined in 2020.

Switzerland had unilaterally reduced the residual tax rate on dividends from 10% to 5% based on this understanding.

Second, Switzerland believed that subsequent OECD members should also qualify for MFN benefits, contrary to India’s position.

Viewing these differences as a lack of reciprocity, Switzerland announced the suspension of the MFN clause, reverting tax rates on dividends and income to the original residual rate of 10%.

How will Switzerland’s decision affect Indian companies?

The suspension of the MFN clause is a setback for Indian firms operating in Switzerland.

Previously, Indian companies benefited from a reduced tax rate of 5% on dividends and other incomes, thanks to Switzerland’s earlier application of MFN benefits.

With the reversal to a 10% residual rate starting January, these firms face higher tax liabilities, reducing their competitiveness when compared with businesses from countries still benefiting from MFN provisions.

What are the broader implications for India?

Switzerland’s decision highlights broader issues in India’s approach to MFN clauses in bilateral treaties.

The Indian Supreme Court’s judgment sets a precedent that could influence how India handles similar clauses in agreements with other trading partners, analysts said.

If disputes over MFN interpretations persist, Indian businesses could face similar challenges in other jurisdictions, potentially deterring outbound investments.

Are there any similar challenges?

Double taxation avoidance agreements are subject to different interpretation many times due to imprecise language, Ajay Srivastava, founder of policy think tank Global Trade Research Initiative, said, while pointing out that Indian software firms faced hurdles over the classification of income under the India-Australia DTAA.

Australia often categorizes payments for software licenses and services as royalties, making them subject to source taxation. Indian firms argue that such payments should be treated as business income, taxable only in India, unless they maintain a permanent establishment (PE) in Australia.

“This mismatch in interpretations leads to potential double taxation and compliance challenges, compounded by Australia’s reliance on domestic laws that may override treaty provisions,” Srivastava said.

Switzerland’s action a wake-up call

The suspension of the MFN clause by Switzerland and earlier issues with Australia underscore the need for India to adopt a more consistent and strategic approach to international taxation treaties, Srivastava said.

“Proactive negotiations to clarify and harmonize interpretations of treaty provisions are essential to safeguard Indian firms’ interests abroad. India must ensure that its treaty frameworks reflect contemporary business realities, particularly in the digital and service sectors, to reduce tax uncertainties and promote global competitiveness,” he added.

Will Swiss firms be affected too?

Foreign portfolio investors (FPIs) based in Switzerland, including those managed by top Swiss banks such as UBS, face higher dividend taxes from their India income, Moneycontrol reported, citing tax analysts.

Switzerland’s move is likely to affect at least 90 Swiss-based FPIs apart from several private equity firms who have invested in companies through the foreign direct investment (FDI) route, the report added.

An email sent to UBS remained unanswered.